New fiscal policy questions

India needs a fiscal road map consistent with the objectives of faster debt reduction

The first Union Budget of the third Narendra Modi government, presented last week by Union Finance Minister Nirmala Sitharaman, improved the fiscal deficit target for the ongoing financial year by 20 basis points to 4.9 per cent of gross domestic product (GDP), compared to the Interim Budget presented in February. This reflected the Union government’s commitment to fiscal consolidation. Even in the last financial year (2023-24), the government restricted the fiscal deficit to 5.6 per cent of GDP, compared to the Budget estimate of 5.9 per cent. Better than expected revenue collection, coupled with realistic Budget assumptions, has helped the government in recent years. It is on course to meet the medium-term target of reducing the fiscal deficit to below 4.5 per cent of GDP by 2025-26.

The government must be commended for adhering to the fiscal glide path, which looked difficult when it was first announced in 2021. Given the fiscal performance in recent years, the government was expected to announce a new medium-term path. Although the Budget did indicate how the government will approach fiscal management in coming years, it raised several questions, which must be debated. Ms Sitharaman in her Budget speech noted: “From 2026-27 onwards, our endeavour will be to keep the fiscal deficit each year such that the Central Government debt will be on a declining path as percentage of GDP.” Since India’s public debt increased significantly after the pandemic and remains a source of vulnerability, targeting a consistent reduction in the debt-to-GDP ratio is an apt fiscal goal.

However, what is not clear is the targeted pace of reduction in public debt. In the current fiscal year, for instance, the government expects central government debt to settle at 56.8 per cent of GDP, compared to 58.1 per cent in 2023-24. At this pace, it would take well over a decade to reach the debt target of 40 per cent as recommended by the Fiscal Responsibility and Budget Management (FRBM) Review Committee in 2017. This, too, would be possible if the economy continues to grow rapidly and there are no exogenous shocks requiring large fiscal interventions over the next decade. Besides, it is unclear whether the overall debt ceiling of 60 per cent of GDP— with central government debt at 40 per cent— as suggested by the FRBM Review Committee is relevant anymore. Both the Indian and global economy have changed significantly over the past decade.

To create more fiscal policy space, India will need a faster reduction in debt over the next several years. Therefore, the government would be well advised to chart a debt reduction path, outlining medium-term targets. A reasonable reduction in debt over a period will also need an operational target. Thus far, it has been the fiscal deficit. It will be critical to determine how much fiscal deficit the government can run to achieve the required level of debt reduction within the given time frame. One of the criticisms of hard fiscal targets is that it tends to be pro-cyclical. But it is partly because of the reluctance to make sufficient corrections in the good times.

Officials have argued the fiscal deficit that can be supported without expanding debt in a normal year is not 3 per cent of GDP— as enshrined in the FRBM Act— but probably higher. However, the objective at this stage should not be to keep the debt stable, but to reduce it at an accelerated pace. Also, it is unclear whether states will  be allowed to follow the same principle of keeping public debt on a declining trajectory without any other constraints. Further, economic growth in the post-pandemic period has been significantly driven by government capital expenditure, which is expected to reach 3.4 per cent of GDP this year. Does the government expect to maintain high spending to sustain growth over the medium term, which will keep the deficit elevated?

Moreover, medium-term fiscal targets have usually taken into account the economy’s ability to finance. If the optimal level of fiscal deficit is above 3 per cent of GDP,  presumably the same will apply to states as well, has the availability of savings to finance it increased in the economy? The latest available number showed that net household financial savings dropped to a multi-decade low of 5.3 per cent of GDP. Even if it recovers, will it go significantly above trend to fulfil the financing needs of the economy? If corporate investment revives, which is an absolute necessity to sustain growth, where will the money come from? If the government continues to borrow at higher levels, the private sector will need to depend on imported savings, which can quickly create complications for external sector management.

Therefore, India’s need for a simple, transparent, and rule-based fiscal framework cannot be overemphasised at this stage of development. This becomes even more important at a time when both the government and the private sector will need global savings for investment. Government of India bonds, for the first time, have been included in a widely tracked global bond index, and more such inclusions are expected. India also expects a rating upgrade, and justifiably so. Overall, India’s fiscal stance after the pandemic has helped. It should build on those gains. India thus needs a comprehensive review of its fiscal position. It requires a clear road map consistent with the objectives of faster debt reduction, sustained economic growth, and the economy’s ability to finance these goals.